As mentioned earlier in the concept of stock trading and investment, there are two main ways to profit from the stock market.
The first is capital gains, which is buying stocks that were expected to grow and rise in price, with the hope of selling them at a high price and making a profit.
The second method is the distribution of profits through the purchase of income shares and shares that generate income from the distribution of these shares to the shareholders.
In addition to the role of these distributions in measuring the strength and growth of their companies, we will try through this article to shed more light on them to understand their nature, role, and impact.
What is the dividend?
In financial management, dividends are the portion of a company's earnings paid to its shareholders, and when the company is making a profit, there are two ways the excess funds can be used.
The company may decide to reinvest the profits back into the business or distribute them to its shareholders for further growth, called retained earnings. Cash is distributed to shareholders in two ways: one is stock buybacks and the other is cash dividends.
A company's ability to pay dividends, or cash dividends, reflects its core strength and sustainability to shareholders. Large companies with sustainable growth often tend to pay regular dividends, unlike small or emerging companies, which prefer, albeit slowly, to protect their profits by reinvesting in growth.
This means that companies that do not pay a dividend to their shareholders are not necessarily for-profit or loss-making companies. Instead, the Board of Directors considered that a revaluation of profits in the company's business would benefit the company and its shareholders more than a cash payment, or that it should hold additional funds to cover other financial issues. or emergencies.
The dividend distribution process goes through some steps as follows:
1. In addition to the profits accumulated as a result of its business activities and transactions in the markets, the company gains profitability for a certain time.
2. The board of directors decides that instead of reinvesting, it should pay some dividends to shareholders and approve planned distributions.
3. The company announces the dividends and their details such as the value of the dividends, the date and execution date, and the profit value per share.
4. Dividends are paid to shareholders on schedule
The importance of dividends to investors
The usefulness and importance of dividends to investors can be summarized in two main points:
1. An important tool for inventory evaluation
Like many other metrics that analysts use to evaluate stock performance, derived from companies' financial statements, such as the price-to-earnings ratio (P/E ratio), the dividend yield provides a useful point of analysis for evaluating a stock's performance. Some consider this to be one of the most important financial information about a company.
The dividend continuity reflects the company's strong performance, and having the real cash flow to pay the dividend gives its financial statements a kind of solid reference for fundamental analysis of the company's strength.
Dividends only change once a year, which provides a more stable point of analysis. Another financial measure that is subject to daily fluctuations in stock prices.
2. Increase profits and reduce risks
Risks are one of the basics of investing in the stock market in general, and any trading or investment process involves risks. Stocks can go up or down for many reasons, sometimes for no known reason.
Therefore, companies that pay a dividend are considered to provide at least a partial return on investment, especially to their shareholders. It is rare for companies that pay dividends to stop distributing their dividends, but in most cases, they increase the amount or percentage of the dividends distributed over time, in addition to three other subplots:
1. Reduce the impact of inflation
For an investor to get a true net return on an investment, the investment must first generate sufficient returns to compensate for the loss of purchasing power caused by inflation.
What does it mean to invest after owning shares for a long time or in the long term, the profit you will earn after the stock rises, the size of the investment return after taking into account inflation at the time of the sale, and the return on investment from dividends in that period.
2. Equilibrium returns in a low-interest rate environment
If you are a fan of fixed-income investments such as government bonds or certificates of deposit and are in a lower interest rate situation, the dividend yield offered by dividend-paying companies is much higher than the interest rates on fixed-income investments.
3. To boost the price of the stock itself
Companies that pay dividends to their shareholders effectively contribute to improving the overall share price. When a company announces a dividend, that stock becomes more attractive to investors.
This increased interest in the company creates greater demand for the stock, which raises its price, which translates to increased profitability for the owner.
The effect of changing interest rates on dividends
This part can be summed up in two points:
1. Impact on corporate profitability
Changes in interest rates have an impact on corporate profitability and sometimes restrict the ability to pay dividends, especially for heavily indebted companies.
Even if the company does not go bankrupt, changes in interest rates can indirectly affect the company's profitability, for example, raising the federal interest rate can raise the price of the dollar, which in turn can reduce the contribution of foreign earnings and thus affect permanently. profitability. to your company.
2. Competition is one of the highest sources of income
When interest rates rise, other sources of return, such as short-term Treasury bills and certificates of deposit, become more attractive to investors because they are fixed-income investment vehicles, especially compared to the risk of stock price fluctuations.
Here's a comparison of dividends vs. bond yields, for example, to assess the relative attractiveness of stocks vs. bonds, which bonds can earn in the event of high interest, and the expected impact at the first point. weaken the share price.
Types of dividends
Usually, dividends are paid on a company's common stock. There are several types of dividends that a company can choose to pay its shareholders.
1. Cash dividends
It is the most common type of dividend, as companies often pay cash to shareholders.
2. Profit share
It is an alternative to paying cash because companies can also pay investors an additional share of the company's stock in an amount equal to the declared dividend.
3. Private earnings
This dividend is paid on all shares of the company's common stock, but it does not repeat as an ordinary dividend. A company usually pays a special dividend to distribute profits that it has accumulated over several years and that it does not need urgently.
4. Dividend Reinvestment Programs (DRIPs)
Dividend Reinvestment Programs Investors in DRIPs can reinvest dividends received into company stock, often at a discount.
5. Preferred dividends
Preferred stock differs from common stock in that it features a preferred stockholder who determines the fixed return received before distributing any dividends to the common stockholders and then taking the profits with them.
equally and if the company is unable to make a profit that meets the distribution amount due. The preferred shareholder acquires because he has not lost his right but can be deferred.
Dividends are usually paid quarterly, but unlike common stock dividends, preferred stock dividends are usually flat.